2013: The year retail rebounds?

By Gary Glick, partner, Cox, Castle & Nicholson LLP

Absent a major upheaval caused by the inability of our politicians in Washington to reach reasonable compromises on debt reduction and the debt ceiling, 2013 could finally be the year when the economy starts to pick up a more significant amount of momentum. It will not be substantial, but with housing and job growth continuing to rise, we may finally start to see the “seeds” of new retail development and the return of may retailers to the marketplace. This could eventually lead to the return of capital to secondary and tertiary markets.



2012 turned out to be a year of slow but incremental growth for the economy; albeit one that was dominated by the presidential political campaign. Employment gains continued at a reasonable if not robust pace, picking up towards the last few months of 2012. The stock market surged, and Europe seemed to have the wherewithal to avert any major sovereign debt crisis. Retail sales for November and December increased about 3% over the same months for the prior year despite hurricane Sandy. Consumer confidence showed signs of growth. According to the ChainLinks Retail Advisors U.S. National Report (the “Report”), the “Conference Board’s Consumer Confidence Index (CCI) reached 73.7 in November 2012. While this remains well below the historical average of 95.0, it is the highest level of consumer confidence recorded since February 2008 when it measured 76.4.” The other major development of 2012 was the “uptick” in the residential housing market. Among numerous commentators, Wall Street seems convinced that the housing depression is over for good: An index of 11 major builder stocks rocketed 80% in 2012 to the highest level since mid-2007. It is ironic to note that the real estate sector that plunged the U.S. into recession may be the sector that is most influential in leading to a recovery in the retail industry.



The biggest obstacle in the way of economic recovery may be our representatives in Washington. Although they were able to avert the first potential “fiscal cliff” crisis by reaching a “last minute” agreement on preventing tax increases most Americans in 2013, it is still incumbent upon them to reach an agreement which would begin to bring down the ever ballooning national debt. To do so, they must avoid the potential devastating impacts of sequestration and a government shutdown or credit rating downgrade in connection with a stalemate over increasing the debt ceiling to pay for already accrued governmental expenditures. Though it has been endlessly politicized, the impact of a government shutdown or credit rating downgrade could be a significant enough shock to the economy that could slide the United States economy back into a recession. However, since the remaining “fiscal cliff” issues are “man-made,” we will assume for the purposes of this Article that the politicians in Washington will show some level of responsibility and fashion a compromise with respect to these issues that will not lead to economic calamity.



As stated in the report, “Retailer expansion in 2013 is still about ‘the sure thing;’ urban over suburban, Class A and B over Class C, and locations with greater population densities and higher income demographics still winning out most of the time.” The same can be said for capital. For the most part, capital in 2013 will chase Class A properties, developers with proven track records and housing and population densities. As was the case in 2012, significant capital was available in the market for the purchase of income producing retail properties meeting these criteria. With interest rates at historical lows and the stock market continuing to show volatility, “cap” rates for these properties remained at historical lows. Also driving investment sales in fourth quarter 2012, was the fear of property owners that capital gains rates would rise in 2013 (which, in fact, they did). Title companies reported more volume in the fourth quarter of 2012 than at any time since 2007. We expect interest rates to continue to remain extremely low for at least the next two to five years, leading to more of the same with investment sales. The only significant change may be the return of capital for less than Class A properties as the economy continues to improve. However, as of this date, although assets in secondary cities and tertiary markets offer greater yields, they continue to be outside the risk/reward threshold of a majority of the investment community.



With respect to the debt markets, lending will have many of the same characteristics we are seeing with investment sales. According to 2013 Emerging Trends in Real Estate (published by the Urban Land Institute and pwc) (“Emerging Trends”), “good assets with solid income streams and good credit borrowers will have no trouble attracting financing from life insurance companies and banks eager to choose from the pick of the litter. As markets improve, more properties will enter this worry-free zone, and rich-can-get-richer mortgagors [will] lock in ‘exceptionally cheap money.’ But players with bad credit and/or marginal assets, who need capital infusions to keep afloat, [will] continue to find themselves cast aside or placed in extend-and-pretend limbo. ‘It is still the best – and all the rest.” In this environment, lenders will continue to hold onto a significant number of underperforming loans. However, as housing continues to strengthen and a market begins to become available for more than Class A properties, some of this product may start to reach the marketplace.



In 2012, portfolio banks continued to lend but remained cautious about underwriting standards and sponsors. Most new loans continue to chase “core” properties in top tier geographic regions. With no secondary market, these banks continue to “lay off” some of the risk of larger loans by bringing in participating banks or co-lenders. Banks are still in no rush to sell distressed assets and take losses.They will continue their preferred strategy of extending many loans with modifications rather than refinancing or disposing of them. As in 2012, they would rather wait for more promising opportunities and avoid balance-sheet issues until markets improve. It is interesting to note that many of the underwater assets of these banks may be among their highest yielding assets as long as these loans remain current. Much like in 2012, typical loan to value ratios for bank permanent loans will range from 50% to 70%. Terms will be short – typically in the 5 to 10 year range with amortization over 30 years, and interest rates will be in the vicinity of 1.5 to 2 basis points over the 10 year treasury yield. Interest rate swaps will continue to be required of many borrowers as a hedge against significant interest rate fluctuations. Banks will also make construction loans to preferred sponsors with development deals in densely populated “top-tier” markets. However, significant pre-leasing will be required. These loans will be short term (i.e., 3 to 5 years), will require significant equity (20% to 40%), will be recourse, and will typically have interest rates in the vicinity of LIBOR plus 3%, with a “floor” in the neighborhood of 5%.



Life insurance companies remained extremely active in 2012, and will continue to be active in 2013, especially without any significant increase in the CMBS market. As with banks, the underwriting of life insurance companies will remain very strict since they have plenty of options available to them. They will continue to originate record volumes, usually with high-credi